Fitch Ratings has affirmed Ceylon Dollar Bond Fund’s Fund Credit Quality Rating of ‘BB-‘ and affirmed the Fund Volatility Rating at ‘V5’. The fund is managed by Ceylon Asset Management (CAM).
KEY RATING DRIVERS
The affirmation of the ‘BB-‘ Fund Credit Quality Rating is driven by the weighted average rating factor (WARF) and rating distribution based on the expected composition of the fund and the fund’s investment guidelines. The fund has a limited investment space as it will only invest in US dollar bonds issued by the government of Sri Lanka, licensed banks in Sri Lanka and Sri Lankan corporates that are rated by an international rating agency. This limits the potential investments to 13 issuances totalling just under USD9bn.
The affirmation of the Fund Volatility Rating is driven by the reduced exposure to interest-rate risk and spread risk, while recognising the fund’s ability to extend duration risk to a greater level than that expressed in the target portfolio. The rating is also affirmed because the target portfolio is not yet fully invested and its ultimate composition remains uncertain, and due to Fitch’s conservative assumptions relating to potential volatility in emerging market debt.
ASSET CREDIT QUALITY
The fund’s updated target portfolio comprises of four bonds – three rated ‘BB-‘ and one rated ‘B+’ – which have been issued by the entities detailed above. The target portfolio is mainly exposed either directly to government or government-guaranteed debt. The fund will invest up to 4% of its assets in US-dollar fixed deposits in a licensed commercial bank in Sri Lanka.
By 17 February 2016, the fund had invested in three of the four issuances in the target portfolio (representing 73.4% of the portfolio). The rest of the funds are placed in US dollar deposits with Deutsche Bank Sri Lanka, a branch of Deutsche Bank AG (A-/Stable/F1+). The fund has struggled to reach a substantial size since its launch in July 2014, partly due to volatility in overall market conditions.
The target portfolio will be concentrated with material exposure to Sri Lankan sovereign risk. The concentration risk is a structural feature given the limited opportunities in the fund’s investment universe. Fitch has conducted stress tests on the target portfolio. Based on its analysis, Fitch believes the fund has a limited capacity to withstand negative rating migration in its investments before it would be downgraded to the ‘B’ category.
PORTFOLIO SENSITIVITY TO MARKET RISK
The updated target portfolio has a shorter weighted average life (WAL) than the original model portfolio based on which we assigned the ratings in July 2014. As a result, the target portfolio has a significantly lower sensitivity to interest-rate risk and spread risk than the original model portfolio. Based on the fund’s market risk factor alone, it could achieve a ‘V4’ Fund Volatility Rating. However, in affirming the rating at ‘V5’, Fitch has taken into consideration the fact that the fund is not yet fully invested so its eventual composition may differ from that of the target portfolio, and that the fund manager does have discretion to extend duration above current levels if it sees fit.
Fitch has also taken wider market conditions- notably potential volatility in emerging market debt – into consideration in its rating decision. According to Fitch’s criteria, funds rated ‘V5′ are considered to have high sensitivity to market risk. On a relative basis, total returns and/or changes in net asset value are likely to experience substantial variability across a range of market scenarios due to substantial exposure to interest rates, credit spreads and other risk factors.
The fund will invest in instruments with a relatively long maturity (WAL of 2.52 years in the target portfolio) except for an allocation of up to 4% to three-month deposits. Therefore the fund will be reliant on secondary market liquidity to meet large redemption requests. However, the fund has access to an overdraft facility of 10%, and requires 14 days’ notice on redemptions above 3% of the fund. On the asset side, it will hold only a limited proportion of outstanding debt issues, all of which will be listed on the Singapore Exchange.
The fund is regulated by the Securities and Exchange Commission of Sri Lanka under the Unit Trust Code, 2011. The fund’s trustee is Deutsche Bank Sri Lanka.
Fitch considers CAM suitably qualified, competent and capable of managing the fund. The investment committee has relevant experience, and the company has sufficient sources of information on which to base its decision-making process. Fitch considers the systems supporting the fund’s investment activities to be satisfactory.
CAM is 21%-owned by Sri Lanka Insurance Corporation Limited (SLIC, BB-/Stable), 69% by Ceylon Capital Trust (Pvt) Ltd and 10% by Commercial Credit and Finance PLC (CCF). Fitch believes CAM has support from the shareholders. However, a key challenge facing the business will be to demonstrate sustained growth in assets under management. The Ceylon Dollar Bond Fund is a key component of its growth strategy. CAM has been managing funds since 1999. The current management team has been in place since 2005, and SLIC and CCF invested in the business in 2010 and 2013, respectively.
The ratings may be sensitive to material changes in the credit quality or market risk profile of the fund. A weakening in the liquidity inherent in the fund or changes to liquidity provisions – such as the manager’s ability to borrow against the net assets of the fund or its ability to delay redemptions – would be viewed as negative. A downgrade of the ratings on the Sri Lankan sovereign or the banks in which the fund has invested its assets, especially the banks whose issues are not government guaranteed, could also lead to a downgrade of the Fund Credit Quality Rating. Changes in exchange-control regulations that could increase transfer and convertibility risks for the fund would also be viewed as negative.
Fitch has capped the fund’s rating at that of the Sri Lankan sovereign (BB-/Stable), given its expected material exposure to the Sri Lankan sovereign. Therefore upside potential for the fund rating is limited.
To maintain the bond fund ratings, CAM will provide Fitch with portfolio information, including details of the portfolio’s holdings and credit quality. Fitch closely monitors the credit composition of the portfolio, the credit counterparties used by the manager, and the overall market risk profile of the investments.